A recent article in Barron’s contains an interview with industry experts about the pros and cons of a growing trend of actively-managed exchange-traded funds (ETFs). In that context, the discussion covered one of the most prominent mutual funds, The Fairholme Fund. One of the experts, Ben Johnson, global director of passive-funds research at Morningstar, stated that:
Q: Are there any strategies not suited for the ETF structure?
“Some of the most successful strategies on the equity side may never end up in this format. Look at Bruce Berkowitz, manager of the Fairholme fund (FAIRX). He is Morningstar’s equity manager of the decade. And yet he is pretty much running from something as liquid as a traditional mutual fund, to say nothing of ETFs.”
The counterpoint to that statement was posted by AdvisorShares:
“Lastly, the prominent mutual fund (Fairholme Fund) cited by Morningstar’s Ben Johnson is a poor example of the type of strategy that wouldn’t be a good fit for the liquidity of an ETF. In fact, the mentioned fund is the perfect example of the inefficiency of the mutual fund structure. In the Fairholme example, a lot of hot money comes in which is more wear and tear on the portfolio manager to put the cash to work. There is a cost to do that: spreads and settlement costs that impact both the new investors and your long-time shareholders. Then something happens: the fund falls out of favor, all the hot money is flying out, the PM is now selling what he can to meet redemption requests with those costs again impacting the departing shareholders, but also being born by the long-term shareholders. In reality, it is the long-term shareholders that will suffer the most by the tax inefficiency of the capital gain generating transactions.”
Luckily, from the Alpholio™’s perspective, it does not matter whether Fairholme is constructed as a mutual fund or an ETF. What really counts is how much value active management by Mr. Berkowitz adds or subtracts on a truly risk-adjusted basis (RealAlpha™). In the past eight years, the results have been mixed.